Question

.6.b - Costs of Various Imperfections: Steinberg Corporation and Dietrich Corporation are apparently identical firms except that Dietrich has more leverage. Both companies will remain in business for one year. The companies’ economists agree that the probability of continuation of the current expansion is 80 percent for the next year, and the probability of recession is 20 percent. If the expansion continues, each firm expects to generate earnings before interest and taxes (EBIT) of $2.7 million. If the recession occurs, each firm expects to generate EBIT of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm pay $1.2 million at the end of the year. Neither firm pays taxes. Assume the required return on Steinberg's debt is 10 percent, and that for Dietrich is 10.5 percent. Assume Steinberg's equity cost of capital is 13 percent and Dietrich's equity cost of capital is 13.2 percent. What is the value of Dietrich’s debt and equity? debt = $1,044,248, equity = $1,061,947 debt = $1,180,000, equity = $1,200,000 debt = $1,067,873, equity = $1,060,071 None of these values are correct.

Answer 1

		Steinberg Corporation	Dietrich Corporation
EBIT	(probability of expansion*EBIT in expansion)+(probability of recession*EBIT in recession)	2380000	2380000
less interest		900000	1200000
EBT		1480000	1180000
cost of equity		13%	13.20%
value of equity = EBT/cost of equity		11384615	8939394
value of debt	Interest /cost of debt	9000000	11428571
value of firm = value of debt+ value of equity		20384615	20367965
None of the value are correct